How to Assess the Value behind Cryptocurrencies

Many of the investors and financial institutions that I talk to are hesitant to invest in cryptocurrencies, often saying that they can’t determine their real value. For example, if we were looking to buy equity in a company, we could look at its fundamentals and make a prudent decision about whether to invest in it or not. Crypto is different in that, it is in its early days and cannot present evidence of a long track record.

Admittedly, the process of value assessment may not be as straightforward for cryptocurrencies as for some of the more traditional asset classes. However, we can still refer to certain other drivers to help us form an assessment of value.

Let’s start with the original cryptocurrency, Bitcoin, and discuss how it compares to gold and commodities.

Valuing Bitcoin – Stock to Flow Ratio

Bitcoin is often valued using the stock to flow ratio, which quantifies the “hardness” of an asset. A report by Bayerische Landesbank found that:

“Applied to Bitcoin, an unusually strong correlation emerges between the market value of this cryptocurrency and the ratio between existing stockpiles of Bitcoin (“stock”) and new supply (“flow”).”

The book “The Bitcoin Standard” by Saifedean Ammous introduced the stock-to-flow approach in relation to valuing Bitcoin. The supply of Bitcoin can be engineered at will. Satoshi set into the protocol a drastic decline in supply growth (due to halving every 4 years). Price is decoupled from mining efforts, so as the price rises, the difficulty of mining Bitcoin increases. Subsequently, new supply, or flow, correspondingly reduces.

The supply profile is guaranteed by the existing setup – if the supply profile were to change, it would adversely affect the peer to peer network that holds bitcoin and dilute the value of their coins.

As a comparison, the stock to flow ratio is the way gold is valued. Gold is used as a store of value in hard times. The supply of gold cannot be increased in huge quantities, and the annual production of fresh gold (“flow”) is limited, adding only incrementally to the existing stockpile (“stock”). So gold is described as having a high stock to flow ratio. However much the price of gold increases, the amount produced will not be increased exponentially, which would dilute the stock to flow ratio.

The next Bitcoin halving is due to take place in May 2020, potentially hugely increasing the stock to flow ratio of Bitcoin. It will be interesting to see what that does to the Bitcoin price.

Valuing according to utility

A cryptocurrency must have a strong use case to incentivize people to have the coins. How useful a coin is feeds through to the value of the coin.

If we take the example of Ether, in order to execute commands and develop applications in the Ethereum blockchain, you need to own Ether. The Ether is converted into “Gas”, which is used to run the network. Ether is, therefore, the currency used to drive transactions and development on the Ethereum blockchain. The more people that are transacting with and on Ethereum, the greater the demand for Ether becomes, eventually leading to a price increase.

“Users will use the infrastructure that offers them the applications they need. And yes, at the moment this is clearly Ethereum. There are more Apps and smart contracts deployed on Ethereum than on all other application-focused blockchain protocols put together.” Max Lautenschläger, Managing Partner, Iconic Holding

Therefore, price of utility protocols is contingent upon the community engaging them and adoption of applications built on top of them. As long as they continue to build and adopt, because it is useful for them, the growing utility that will continue to drive value.

There are many other types of cryptocurrencies and crypto assets, as my colleague highlighted in a recent article. Crypto may be in its early stages and be extremely volatile, but traditionally-minded investors and financial institutions can rest easy knowing there are standard ways through which value can be calculated.

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This article is strictly for educational purposes and isn’t to be construed as financial advice.

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